If the cap fits …

As the ongoing rise in raw materials prices has been brought into sharper focus by the oil price spike occasioned by the Colonel’s little local difficulties, several varieties of myths, half-truths, and Laputan impossibilities have once again begun to infest the punditosphere to the point where the still, small voice of rational analysis is in danger of being entirely drowned out.

Arguably taking the palm among these is the ludicrous suggestion that a country such as Japan – a land erroneously believed to be languishing in ‘deflation’ (as opposed to being one enjoying the productivity-led benefits of modestly-declining prices amid a mildly increasing nominal supply of money and credit) – might, in some perverse, reverse-causality way, benefit from the fact that one important subset of its external suppliers has suddenly presented its householders and businessmen with a much larger bill for its wares than has been its wont. Indeed, so powerful is the taboo associated with a fiat money not declining in value fast enough to satisfy the braying herd of underconsumptionists that it allows seemingly sane individuals to advance such a thesis even though they are simultaneously to be heard expressing the fear that when the self-same misfortune visits some supposedly less blighted population – i.e., their own – the ‘tax’ it represents cannot fail to pose a severe threat to their continued well-being.

What the mainstream fails to consider is that if higher oil prices are a ‘tax’, then so are higher banana prices, or higher T-shirt prices, or higher soda prices. What its members therefore overlook is that the development of higher prices everywhere – a state of affairs towards whose attainment they all mindlessly applaud the Federal Reserve for striving – is not a blessing of modern monetary manipulation, but a bane.

Implicitly a member of this same school of cart-before-the-horse Keynesians is former presidential advisor, Christine Romer. She it was who used the pages of the NY Times last weekend to perpetuate the fallacy that when Roosevelt and his pet monetary cranks were ploughing under food and slaughtering herds – even as people in the land were literally starving – or when they were arbitrarily tinkering with the price of gold in semi-occult fashion over the great man’s breakfast egg, their soi-disant courage in abandoning what was then the economic orthodoxy brought about a rapid end to the Depression. This conveniently ignores the fact that the slump, in fact, turned out to be much more profound and protracted in New Deal America than in most other advanced nations – so much so, indeed, that a different strain of General Theory counter-inductionists frequently pops up to assure us that the horrors of World War II also had their silver lining in that the blessed upsurge in ‘consumption’ associated with tens of millions of deaths, the reduction of whole cities to cinders, and the delivery of half the globe to Communist tyranny did at least finally dispel the bogey of persistent over-capacity.

Warming fully to her theme, Ms. Romer went much further in her haruspications, insisting that if only the higher councils of the Federal Reserve were not now populated exclusively by ‘monetary hawks’ (sic), that hidebound bastion of monetary rectitude could ‘engage in much more aggressive quantitative easing, both in size and in scope, to further lower long-term interest rates and value of the dollar.’

Meanwhile, that glowering eagle among the preening hawks, Chairman Bernanke himself (no, really, this is just too much even for irony!) had the gall to tell a European audience that none of the world’s present problems were his fault. He even wheeled out the hoary old fable of the ‘global saving glut’ – something we thought had been laid to rest alongside its complementary, pre-Crash idiocy of a ‘global asset shortage.’

As the man behind the screen of the most important economy in the Land of Oz, Bernanke is presumably not unaware that the sins of both omission and commission of which he is guilty when managing the world’s reserve currency must have wider ramifications. So, when we talk of ‘saving gluts’, what we really mean – as no less a figure than Otmar Issing pointed out a few years ago – is not so much the voluntary, ex ante desire to forego a last nickel-and-dime, present consumption of American goods and services as it is the unfortunate result of the pressing, ex post difficulty of disposing of the vast surplus of new dollars routinely being created with the full and enthusiastic blessing of the Fed.

It is hardly a coincidence that, during a decade which we now – rather belatedly – recognise as one during which dangerous ‘imbalances’ were building up (even if we have yet to admit the direct culpability for this of the ill-starred central bank measures taken to compensate for the Tech bubble which inaugurated the period), the US ran cumulative current account deficits of no less than $5.8 trillion dollars, a figure equivalent to more than a fifth of the simultaneous rise in global GDP. Given that this last measure is implicitly biased towards end-consumption – of however ill-judged a form – it should be a sobering thought that so much of its increase can be laid at the door of an American profligacy whose bitter legacy is the increasingly unsustainable weakness of the country’s finances.

To put that enormous sum into perspective, we can note that the cumulative, ten-year deficits run up by all other OECD-member nations plus India and Brazil came to ‘only’ $3.8 trillion, or fully a third less than the US overspend. Depending on your taste, we can say that the US alone was responsible for eating up the equivalent of all the surpluses generated by the world’s six biggest, non-oil, exporting nations (China, Japan, Germany, Switzerland, the Netherlands, and Taiwan), or for almost twice the surpluses racked up by OPEC and Russia, combined, in a period when energy prices hit all-time, nominal dollar highs.

It further tells us something of how correctly to apportion the blame for the presently inflamed nature of markets for both goods and assets when we see that, even in these last two years of supposed American ‘de-leveraging’ and enforced credit stringency, the US current account gap has still managed to amount to almost half the overall total registered by the entire roster of OECD deficit nations, taken all together.

Now, it is true that the recipients of that Gilgamesh-like flood of Uncle Sam’s suspect IOUs were not bound to pile them up in the local SWF or CB/Treasury foreign exchange account but neither is it obvious that simply to refuse all assistance to the local acquirers of dollars – leaving these to dispose of them in their own individual way – would have greatly mitigated the subsequent evils. After all, there was no official currency pegging at work in Continental Europe (not outside the pernicious system which bankrolled the importunate PIIGS, at least), yet hard-won, Teutonic and Swiss export dollars were still put to work by the local banks in financing some of the most arrant follies of the US credit bubble.

Incidentally, for all the accusations of ‘policy manipulation’ being bandied about, we should note that, notwithstanding the risible declarations of hewing to a ‘strong dollar’, the Greenback has fallen further in value over the decade in question – on a real, effective, trade-weighted basis – than all bar a handful of economic basket cases and one overt mercantilist.

Nor is it exactly a coincidence that an overlay of the US current account with the GDP figures for residential investment makes such a neat match. Unable to render a material settlement for the manifest of the Rest of the World’s wares they desired, due to their nation’s growing lack of industrial competitiveness, Americans simply took to buying and selling each other houses on a highly disproportionate scale, inadvertently providing the collateral necessary to attract funds back into the country and so to balance the books, without overly scaring the dollar’s owners with an even faster pace of depreciation than was already in train.

Here it is not necessary to imagine that all the incoming surfeit of consumer goods was itself bought on tick, but only to countenance the idea that some of the proceeds of the credit-fuelled, phoney prosperity being fostered by Bernanke’s ‘making sure it doesn’t happen here’ were routinely leaking abroad, contributing to a raft of misguided entrepreneurial, as well as banking, decisions there, too.

Think of it as if a successful US property developer, building contractor, realtor, mortgage broker or CDO packager – in addition to a cash-out refi junkie – had spent a non-trivial portion of his earnings on a chunk of Chinese electronic and German automotive excellence – shipments for which there were insufficient local goods either to act as passable substitutes or to be accepted in payment by the foreign vendors. Note, in passing, that this lack arose in good part from the fact that too many people had become involved in non-tradable, debt-financed activities, like housing, defence, or government in general because the preferential provision of credit to those sectors made them seem far more lucrative undertakings than the tough sledding of out-competing overseas manufacturers was deemed to hold in prospect.

The vicious circle which all this entailed would then be completed when the PBOC sequestered the dollars from the first sale and the local Landesbank received as a deposit those arising from the second, whereupon each institution would feed them back to those providing the mortgage finance from which our flat screen-watching, Beemer-driving hero was either making his living or eating his seed-corn.

Do not misconstrue the argument here: the natural expansion of monetary means in the surexporting nation is not in itself an evil – this is, after all, exactly what the classic price-specie mechanism of self-regulating, negative feedbacks comprises. Nor do we wish to suggest that to make sales on credit is somehow not a vital part of a functioning economy, or that it is inherently reprehensible. True, such business should be conducted judiciously with a careful eye to the chances of repayment and a wise consideration of what the real value of the repaid monies is likely to buy, but without any such facility, the world would undoubtedly be a much poorer place.

Where these both go wrong, however; where they become detrimental to the chances of sustained material progress is when two intertwined distortions are introduced by our modern day, state-directed, financial apparatus.

The first of these occurs when what started as credit – i.e., the willing, contractual surrender of the lender’s ability to buy present goods in favour of an accelerated capacity to acquire them on the part of the borrower – is turned, by the chicanery of fractional reserve banking, into money. Now, A does not cede his own ability to buy to a cash-strapped B, but rather has his bank alchemically transmute the narrow earnests of future payment – which A cautiously accepted from B presumably in accord with his specific knowledge of his counterparty – into the freely-employable, instantly transferrable, general medium of exchange we call money.

In this way, A no longer has to wait for B to redeem his promises by offering something of equal, produced value – either directly to A, or to the world at large in exchange for its money – before he, A, can enjoy more goods for himself. This means that a discrepancy has arisen between the quantity of goods at hand and the amount of the money with which to compete for them, all thanks to the legally unexceptionable, but logically invalid transmogrification undertaken by the CB-backstopped, fractional banking system. This may or may not manifest itself as what is today called ‘inflation’ – i.e., a rise in a statistically-massaged index of consumer goods and services – but it ineluctably perverts the market signalling process by altering the relative prices of present goods and by introducing an artificial element of presumed capital availability into the discount afforded to future goods.

Nor do its evils end there, for this overlap of claims to instant satisfaction also imbue the whole edifice with an alarming degree of instability due to the fact that, should too many people seek simultaneously to exercise such theoretically valid claims, their practical illegitimacy will be revealed and the whole shame edifice of modern banking will tumble, spreading ruin far and wide.

Given the CB’s prime agency in giving the illusion of stability to what is an inherently unsound and definitionally illiquid system, as well as in distributing the Danegeld by which it props up those Too-Big-To-Fail when their own marauding threatens their survival, it – and it alone – is what promotes the financial engineers’ gross, debilitating hypertrophy. Thus, the blame for all the consequent ills of this fundamental violation of free-market principles must lie with it and with it alone The more important the central bank, therefore, the larger its degree of incrimination in this destruction of wealth, whatever casuistic pleading Mr. Bernanke may advance to the contrary.

This first, disastrous act of interventionism is further compounded by the collusion between central banks by which they agree to treat each other’s infinitely reproducible liabilities as part of the foundation for the issue of those very same liabilities. Here we elevate the perils of fractional reserve banking to the very pinnacle of our system, entangling both the chronic reserve acquirer and the chronic reserve over-issuer in a cloying web of mutual fear and temptation while perpetuating – on a transnational scale – what should have been a transient gap between the ends and means of cross-border buyers and sellers. As an historical aside, it was the rupture which took place along the similar fault-line of pig-on-pork, reserve double-counting inherent in the intra-war gold exchange standard – as preached by Keynes before he degenerated into an autarkical inflationist – and not the failure of a proper metallic standard which so magnified both the initial tremors and policy errors of 1929-30 that the shock mounted far up the financial Richter scale and so resulted in the worldwide calamities of 1931-3.

In a well-functioning system – a precious metal specie standard, for example – matters would proceed at the macro scale just as they ordinarily do at the personal (micro) level. The greater abundance of money in the (net) exporter’s pockets would tend to reduce its marginal utility to him, leading him to value both goods and the labour he expends to acquire them correspondingly higher in comparison to it, thus raising their price and gradually lowering his competitiveness. Conversely, a reduced quantity of money in the pockets of the (net) importer would leave him feeling a lack which should bring about an equal and opposite restoration of relative valuation and pricing. Acting both together, these shifts would provide an ongoing impetus back towards a dynamic balance, well before the whole productive apparatus became locked into a highly sub-optimal pattern of over-exposure to an ever less creditworthy, foreign customer base which relies too little on its own, savings-starved industry to generate exchangeable worth and too much on adding to the crushing burden of associated, offshore obligations it has issued.

Rest assured, there would still be trade surpluses and trade deficits under an unhampered system of payments, but they would never loom anywhere so large if the addition to the money-backing reserves of those in credit could only come about by means of an equal-and-opposite reduction in the reserves of those in debt – a natural motion for which the over-optimistic dependence on a commensurate adjustment taking place in unanchored, often wildly fluctuating, exchange-rate parities is a very poor substitute as well as impracticably bad politics. Then again, such an ‘economics of illusion’ – in preferring a stealthy erosion of the capital-eaters’ living standards via external devaluation to a more honest recognition of the effects of their profligacy through internal revaluation – is par for the course for the Keynes-inspired mainstream of inveterate money illusionists

By contrast with the natural, Humean process of zero-sum reserves, the present system represents nothing less than a scheme of Perpetual QE on the part of dollar-buying central banks; one which therefore exerts little or no discipline on the politically-pliable proclivities of the dollar-issuing central bank, as Jacques Rueff famously recognised with his allusions to the ‘deficit without tears’, ‘the childish game of marbles’, and in his fable of the foolish tailor ever willing to swap suits for his customers’ freely-issued IOUs.

If, in normal circumstances, even the most dyed-in-the-wool inflationists can recognise the inadvisability of pursuing ‘orthodox’ QE (a denomination to which we are forced since a deviancy so widely-practised can hardly now merit the adjective, ‘heterodox’), because of the lack of restraint it implies upon all those wishing to borrow money – not least among them the insatiable Jacobin meddlers who toil infernally in the bowels of the Provider State to fence in our freedoms – so we should condemn, out-of-hand, this whole, ongoing business of QE-by-proxy in no less vehement a manner.

That does not, however, lead to the verdict that it is all the fault of the Others and that the Fed stands pristinely absolved of all crimes. After all, the Others are perforce operating under doctrines promulgated by, and within an institutional framework minutely devised by, the global hegemon; an admixture which consists of erroneous conclusions, falsely drawn – à la Romer – from the trauma of the Great Depression, and venal, full-spectrum dominance, self-interest.

Thus, though neither the diligent Mr. Wu nor the assiduous Herr Meyer could have been expected to realise it, what they were engaged in was not the investment of some of the fruits of their successful, overseas business endeavours in the American property market, as much as in the often indirect provision of finance to their own customers – affording these the means to continue to buy their goods—albeit in a form issued against the dubious security of a condo possibly owned by an entirely unrelated third party of increasingly questionable standing.

Hence, when the Chuck Prince Charleston suddenly stopped in 2008, the initial impact was just as dramatic on the market for machine tools, ceramic magnets, and silicon wafers as it was on lumber, carpets, and dishwashers and, so, the shock hit the surplus nations every bit as hard as the deficit ones as they all realised, to their horror, that they had all become nothing more than imprudent, Rueffian tailors.

Since then, of course, the game has been replayed at an even more frantic pace, with governments largely taking pole position as the drivers of deficits, the media of monetization and, hence, the inflamers of inflation. No-one is wholly innocent in this regard, but it is clear that, if the PBoC has vied manfully with the Fed for the laurels for much of the course of this dreadful race to the bottom, only the latter institution was guilty of redoubling its efforts at just the wrong moment last year – and only this institution was hubristic enough to accompany its outrage with the nakedly inflationist manifesto issued by its Chairman amid the high-profile mediafest of the Jackson Hole confabulation.

By the time this last blunder works its way through the system, it will not just be the world’s tinpot tyrants and biddable client kings who will pay the price for the Fed’s reprehensible policy of ‘après moi le déluge’, but it will be the ordinary man and woman who will have occasion to rue a programme so replete with intellectual arrogance, power-worship, and a wilful blindness to its awful, unintended consequences that only a Krugman could approve of it.

Updated 2011-03-07

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One reply on “If the cap fits …”
  1. The above article contains what I think is the longest sentence I have ever seen. It’s the paragraph starting “Implicitly a member….”. This paragraph consists of just one sentence: 185 words. Is this a record?

    I suggest this “wordiness” (for want of a better word), does not pay off. People with the brain the understand the convoluted language will see the faults, if any, in the underlying arguments. As to dummies, they’ll give up after the first few sentences (or half way thru the first sentence, if it’s a “185 worder”).

    So much for Sean Corrigan’s style. Now for the economics. I agree that fractional reserve (FR) is a flawed system, but I don’t agree with Corrigan’s reasons.

    He claims that FR creates money out of thin air. In particular he claims that when A lends to B, A’s freedom to spend is not reduced. (Passage starting “Now, A does not cede his own ability to buy to a cash-strapped B…..”).

    That is true as far as it goes. But what does happen is that B normally supplies A with collateral, e.g. ownership of B’s house if B fails to repay a mortgage. This reduces B’s ability to sell the house (or the equity in it, to be exact) and spend the proceeds.

    In more general terms, in a free market, people are normally cautious and responsible with borrowed money. They don’t go on irresponsible, inflation boosting spending sprees with such money because this behaviour normally ends in bankruptcy.

    Of course where 95% of mortgages are government backed (as is the case in the U.S.), plus where the central bank guarantees to rescue the criminals, incompetents and fraudsters who run large banks, things are very different: FR is likely to run riot. But this is not a fault of FR as such.

    I suggest the basic fault in FR is the INSTABILITY to leads to. That is, the economy expands a bit, which in turn makes various forms of collateral look better, which in turn leads to more lending, etc etc. Untill the crash comes. Walter Baghehot described this cycle. So it’s been going on for a long time.

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